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Sunday, June 19, 2011

How We Know What Isn't So: Chapter 6

Value investors believe the market is not perfectly rational. To understand why, an examination of human behaviour is required. In How We Know What Isn't So, which is recommended by a number of value investors and behavioural economists, Thomas Gilovich explores the fallibility of human reasoning. Only by understanding our flaws can we seek to improve on them, thereby ameliorating our decision-making processes.

The previous chapters have spent a great deal of time discussing our own flaws in how we interpret and internalize information we encounter directly, but much of what we know comes not from direct experience but from what we have read or heard. This chapter examines biases in secondhand information that distort reality and reduce the reliability of information we come to count on.

"Sharpening and leveling" is what Gilovich calls the process that tends to obliterate the truth when it comes to secondhand information. When someone hears a story, for example, they focus and enhance (i.e. sharpen) the interesting elements of it and weed out (i.e. level) the inconsistencies. This process was demonstrated in an experiment where subjects were asked to describe a series of events that they witnessed. A new set of subjects was then asked to re-describe the events but this time based on the notes of the original subjects. The descriptions of the second set of subjects were much more extreme and one-sided than those of the original subjects, which Gilovich attributes to the fact that the original subjects sharpened and leveled what they saw.

There are many reasons sharpening and leveling takes place. Often, the teller of a story wants to entertain. Other times, he may be trying to make a point, or make a convincing argument (e.g. he may have a political axe to grind), which serves to distort the truth from ever reaching the listener.

Along with entertainment value, another factor that causes secondhand stories to propagate is how plausible, ironic or shocking they are, regardless of whether they are true. All of these issues are at play in the news media, where the demand for news is so strong that the supply grows to fill it. Gilovich takes us through a couple of examples where this occurs, including biased coverage of the AIDS epidemic from what are considered reliable news media sources.

To avoid falling prey to secondhand misinformation, Gilovich advises the reader to trust facts rather than projections, to look out for sharpening and leveling (for example, if scientists give a range such as 1% to 20% for an infection rate, the media will say something like "the infection rate may be up to 20%"), to consider the source, and to be wary of testimonials.